Regulatory Impact Statement

Exempting councils from the land tainting tax rules

Agency Disclosure Statement

This Regulatory Impact Statement (RIS) has been prepared by Inland Revenue.

It provides an analysis of options to address problems with the “land tainting rules” in the Income Tax Act 2007. The land tainting rules were introduced to combat tax avoidance, but overreach by taxing land that is used in business where there is no tax avoidance concern. As a result, these rules distort decision making – for example, a decision to keep or sell land may be driven by tax, rather than what makes the most economic sense. Further, the rules increase compliance costs as businesses obtain legal advice to mitigate the impact of the rules, and monitor purchase dates and the length of land ownership in order to determine whether a disposal is taxable under the rules. An example,discussed in this RIS, of where this is occurring is in the context of Auckland Council.

The preferred option removesthe overreach of the rules and the associated economic distortions and compliance costs for council groups byexempting them from the associated persons provisions in the tainting rules. However, this option would not resolve the issue for other taxpayers affected by the rules.

A key gap in the analysis is that Inland Revenue does not hold sufficient data to provide an estimate of the fiscal impact of the options. An assumption made was that council groups would restructure if an amendment is not made. Without this assumption, options 1 and 2 would have fiscal impacts.

Inland Revenue has consulted the Treasury, the Department of Internal Affairs, Auckland Council, and Auckland Council’s tax advisors. These parties are supportive of the conclusion reached in this RIS.

Other affected taxpayers were not consulted because of time constraints – Auckland Council seeks assurance as soon as possible that a legislative amendment will be made in order to provide certainty of tax treatment, so that development activities proposed to be undertaken by Development Auckland do not distort the decision making of the Auckland Council group. This time constraint has meant that one of the options – extending the business premises exclusion in the land tainting rules - was not able to be fully considered.

None of the policy options would impose additional costs on businesses, impair private property rights, restrict market competition, reduce the incentives for businesses to innovate and invest, or override fundamental common law principles.

Mike Nutsford

Policy Manager, Policy and Strategy

Inland Revenue

4 February 2016

STATUS QUO AND PROBLEM DEFINITION

Current tax rules

1.Generally, the proceeds from the disposal of land held on capital account are not taxable. However, in certain circumstances, the proceeds are taxable under the land disposal provisions contained in sections CB 6 to CB 23B of the Income Tax Act 2007. The sections that most commonly apply to land owners who are not land dealers, developers or builders, provide that the proceeds from the disposal of land are generally taxable if:

  • the land was acquired for the purpose or with the intention of disposal (section CB 6); or
  • the land was acquired for the purposes of a business relating to land (section CB 7).

2.Part of the land disposal provisions are the “land tainting rules” which are contained in sections CB 9 to CB 11 of the Income Tax Act. For the purposes of this RIS, the relevant parts of the legislation are sections CB 9(2), CB 10(2) and CB 11(2) of the Income Tax Act 2007. These provisions include in the tax base land owned by an associated person of a land dealer, developer or builder, if it is acquired or improved at the time the dealer, developer or builder was in business and is disposed of within 10 years of acquisition or improvement.

3.The Income Tax Act provides rules that govern where a person is associated with another person[1]. Generally speaking, a person is associated with another where there is a sufficiently close relationship between the two parties. The most relevant test for the purposes of this RIS is the company association rule, which provides that two companies are associated where a group of persons hold voting interests in each company of 50% or more.

Policy intention behind the land tainting rules

4.Before the land tainting rules were introduced there were evidentiary problems with proving a person’s purpose or intention, which meant that a developer was able to avoid tax by claiming that properties were held as investments[2] or by holding properties in the name of an associated person[3].

5.To combat this tax avoidance, in 1973, the Government introduced the land tainting rules.[4] These rules supplement the purpose/intention test[5] by providing an objective “bright line” rule under which developers and persons associated with them are taxed on land disposals made within 10 years of purchase or improvement. As purpose or intention are not part of the tainting rules, the associated evidentiary problems and tax avoidance no longer occur.

6.Although it was recognised that such a blanket rule could result in capital account land being subject to tax in certain circumstances, it was a deliberate decision by Parliament that all gains on land sold by property developers and associated persons within 10 years of acquisition should generally be taxed.

Exclusions from the rules

7.In order to reduce the circumstances in which the tainting rules would tax capital account land, residential land and business premises are excluded from the rules. For the purposes of this RIS, the business premises exclusion contained in section CB 19 is the most relevant. Put simply, this provision excludes from the tainting rules premises that are occupied mainly to carry on a substantial business.

The problem

8.The tainting rules are overreaching by taxing capital account land used in businesses of persons associated to a property developerin situations where there is no tax avoidance concern.

Capital account land used in business

9.The business premises exclusion is narrower than is required to ensure the tainting rules achieve their objective of combating tax avoidance. For example, it has been held that:

  • The provision only applies to land with buildings on them, not to a business solely involving land.
  • The land must be physically occupied by the taxpayer.
  • The taxpayer is required to be carrying out their business operations from the property because of the definition of “occupation” and that “carry on” implies a repetition of acts or a habitual course of conduct, which is to occur “from” the premises.
  • Substantial business must be carried on from the land – for example, it has been held that a storage facility does not fall within the exemption.

10.It is fact specific as to what falls within the ambit of this provision. For the most part, a person associated with a developer would not be taxed on land they dispose of that has been used as their business premises. However, there could be circumstances in which capital account land used in the business does not fall within the exemption and, therefore, is subject to tax. It is recognised that capital account land should be subject to tax to a certain extent as it would not be possible to create a workable rule to determine whether the land is held on capital account in every scenario unless purpose and intention are introduced into the rules.[6] Even so, it is considered that the business premises exclusion results in capital account land being subject to tax more than is necessary to prevent tax avoidance.

11.Therefore, capital account land that is used in business could be taxable in circumstances when there is no tax avoidance concern. For example, an ice-cream manufacturer (who is associated with a property developer) purchases a storage facility to store materials used in his business. He sells the storage facility 9 years later because a downturn in business means it is no longer required. Even though it is clear that no tax avoidance is occurring, this transaction would be subject to tax under the tainting rules because it has been held that the business premises exemption does not apply to storage facilities.

Application of the tainting rules to Auckland Council

12.A further example of the rules taxing capital account land genuinely used in business occurs in the context of Auckland Council (AC) subsidiaries[7]. AC, through its subsidiary Development Auckland (DA),[8]will be undertaking land development activities that seek to increase housing supply by creating infrastructure that allows for intensification of development in the Auckland region. It could also be involved in social housing developments in the Auckland region, although this would only form part of its development role.

13.Council subsidiaries are subject to tax, whereas councils themselves are exempt as local authorities. Therefore, as DA will be undertaking land developments, it is likely to be considered to be carrying on a business of dealing in land, developing land or erecting buildings. The result of this is that any gain on the disposal of land by other council-controlled organisations (“CCOs”) and port, energy and electricity companies controlled by AC could be taxable if the land has not been held for more than 10 years or if the disposal is made within 10 years of completing improvements to the land. Put simply, land held by other entities in the group that would not ordinarily be taxable upon disposalmay be taxable simply by virtue of these entities’ association to the development entity.

Overreach in the context of Auckland Council

14.The tainting rules are overreaching by taxing capital account land that is genuinely used in the business of AC’s subsidiaries. The tainting rules were introduced to prevent avoidance, however it is clear that the land held by the subsidiaries is not held in order to avoid tax for DA, because:

  • The subsidiaries of AC are holding land necessary for their operations to ensure that they are individually accountable for its use and able to more easily make commercial decisions in relation to the land;
  • They have held land prior to any entity in the group being considered a developer;
  • If the AC group were intending to avoid tax, it would not develop land in a taxable entity such as DA, nor would it hold land in its taxable subsidiaries. Instead, AC would undertake the development itself and lease all necessary land to its subsidiaries. This would have no tax effect, as AC is exempt;
  • The subsidiaries of AC are operated independently of each other, with distinct businesses and objectives. They are so independent that each subsidiary has its own separate board and makes decisions without reference to AC or the other subsidiaries. Therefore, any land held by a subsidiary is likely to be unrelated to the development activities of DA.

15.Some of the land held by the council group may fall under the business premises exemption in CB 19. However, we have been made aware of numerous examples of land that may not fall within the exemption, resulting in a potential tax liability of multi-million dollar value.

16.In order for DA to proceed with its development activities with any certainty about the tax implications for the AC group, AC’s subsidiaries would need to seek a binding ruling on each individual premises that is on the borderline of the exemption. This would have significant compliance costs and delay essential developments. Even then, capital account land that does not fall within the exemption could still be tainted.

17.AC has suggested that assurance that an amendment will be made to resolve this issue should be provided as soon as possible so that DA can undertake its development activities with certainty of tax treatment.

Consequences arising from the rules

18.The tainting rules distort the decision making of businesses and result in excessive compliance costs. The extent of these consequences is described below in the context of Auckland Council.

Distortions to decision making

19.In the past, the AC group has specifically restricted the operations of its subsidiaries to prevent them from being considered land developers due to the tainting implications.

20.Following the formation of DA (which will be considered a developer) and without any legislative change to address the issue, the AC group may structure land holdings in a way that minimises the impact of the tainting rules even where (ignoring tax) doing so does not make economic sense. For example, if AC owns all group land and leases it back to the relevant subsidiaries it will not be taxable on any disposals. The property would still be tainted, but there would be no tax effect, as AC is exempt from tax. This type of structuring would not lead to good governance as AC subsidiaries would need approval from the council board in order to make commercial decisions in relation to land leased to them.

21.Even if this were not to occur, the tainting rules would affect business decisions in other ways – for example, a decision to keep or sell property could be dictated by tax rather than by what makes the most economic sense. Furthermore, the AC group may refrain from undertaking certain activities because of the tax effect.

22.Although taxes generally impose economic costs because they induce individuals to make decisions that they would not have made in absence of the tax, a principle of the Government’s broad-base, low ratetax policy framework is that tax should not, as far as possible, affect people’s decisions.

Excessive compliance costs

23.In addition to affecting commercial decisions, the tainting rules as they currently operate increase compliance costs for AC. AC is likely to continue to obtain expensive legal advice in order to mitigate the tax effects of the rules unless an amendment is made. Furthermore, there is the added compliance cost of having to consider the impact that the transactions and activities undertaken by one subsidiary have on the tax position of the others. This is particularly burdensome given the autonomy and independence of the council subsidiaries.

Wider implications

24.We consider that these impacts apply to any situation where the land tainting rules tax capital account land genuinely used in business by a person associated with a builder or developer. This mainly occurs in council groups and large corporate structures where many different businesses (as long as one of them involves property development) are owned by the same parent. DIA have informed us of other council groups who are negatively impacted by the tainting rules; we have no measure of the scale of the problem in relation to the private sector, although we have received anecdotal evidence suggesting it is a problem.

OBJECTIVES

25.The objectives against which the options are to be assessed are to:

(a)Remove tax impediments to AucklandCouncil’s development and housing objectives;

(b)Improve the coherence of the tax system overall;

(c)Improve the equity of the tax system;

(d)Improve the economic efficiency of the tax system and minimise deadweight costs as far as practicable; and

(e)Reduce compliance costs.

26.All objectives are weighted equally. There may be trade-offs amongst the various objectives. For example, a specific exemption for councils would best meet objective (a), but would be inconsistent with objective (c) as it provides preferential treatment to councils over other entities.

27.AC seeks assurance as soon as possible that a legislative change will be included in the next available tax bill (currently scheduled for introduction in March 2016), so that DA can proceed with its developing activities without distorting the decision making of the AC group. This feature presented a timing constraint on the extent of the analysis that could be undertaken.

REGULATORY IMPACT ANALYSIS

28.Three options for change and the status quo have been considered for addressing the problem and achieving the stated objectives. The options are:

  • Option 1: AC exemption – Exempt AC subsidiaries from the associated persons provisions in the land tainting rules.
  • Option 2: Council exemption – Exempt council subsidiaries generally from the associated persons provisions in the land tainting rules.
  • Option 3: Extension of the business premises exclusion – Extend the business premises exclusion in the land tainting rules to ensure that more capital account land used in business falls within it, while also upholding the integrity of the tainting rules.
  • Option 4: No changes are made to the land tainting rules. This is the status quo option against which all other options are compared below.

Option one

29.Under this option, there would be an exemption for AC subsidiaries from sections CB 9(2), CB 10(2) and CB 11(2) of the Income Tax Act. The effect of this is that the land held by other AC subsidiaries would not be tainted by the development activities of DA.

30.The subsidiaries will still be subject to tax under the land disposal provisions in sections CB 6 to CB 13 – for example, if they:

  • are considered to be developers, dealers or builders themselves (sections CB 9(1), CB 10(1) or CB 11(1).
  • undertake certain development or division work (section CB 12 or CB 13).
  • acquire the land with the purpose or intent of selling it (section CB 6).
  • acquire the land for the purpose of a business relating to land (section CB 7).

31.It is only the associated person aspect of the tainting rules that the subsidiaries would be exempt from –that is, the development activities of one subsidiary would not taint land owned by another subsidiary.

32.Additional property purchased by DA would still be “tainted” by its own development activities – for example, if DA purchased land that was not for development purposes, it would still be subject to tax upon sale, provided the necessary requirements in any of sections CB 9 to CB 11 were met.

Assessment against objectives – option one

  • Removal of tax impediments to Auckland Council’s development and housing objectives: The tainting rules would not impede DA’s development objectives under this option, as the subsidiaries of AC would be exempt from the rules. This option meets thisobjective.
  • Coherence:Coherence would be improved under this option. The unintended consequences of the tainting rules would no longer arise for the subsidiaries of AC (that is, they would no longer be taxed on the disposal of capital account land). This option partially meets this objective as it resolves the overreach of the tainting rules for a specific group, but does not resolve the issue for other groups.
  • Equity: It may be seen as unfair for the subsidiaries of AC to be exempt from the tainting rules when other taxpayers are not. This could encourage other entities to lobby for similar treatment. However, this option partially meets the equity objective as it improves the fairness of the tainting rules for Auckland Council when compared to the status quo.
  • Economic efficiency: The distortions to decision making associated with the impact of the tainting rules would no longer affect AC. Due to this option’s limited scope, it only partially meets this objective.
  • Compliance costs: Compliance costs would be reduced as AC would no longer incur compliance costs obtaining legal advice to mitigate the impact of the rules, or from monitoring the length of land ownership. Due to this option’s limited scope, it only partially meets this objective.

Option two (officials’ preferred option)